The Impact of Rising Interest Rates on Emerging Markets Bonds

The Impact Of Rising Interest Rates On Emerging Markets Bonds

Stephan Mathis

Webster University

Finance: 5000

September 24, 2015

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The Impact Of Rising Interest Rates On Emerging Markets Bonds

     A fed rate rise would create problems for emerging markets economies’ bonds, and stock and would prompt investors to find solutions to mitigate loss.  The increasing globalization of financial markets over the past decade has shown a growth of capital investment into emerging economies’ bond market.  The greatest risk to these bonds is not political instability, but rising interest rates and inflation.  The possibility in the rise of rates has brought volatility in the emerging bond market. Investors have come up with remedies to lesson the effects of future interest rate increases. Investors charge risk premiums to emerging bond prices to offset risk, because of the uncertainty.

     The greatest risk to emerging market bonds is not politics, but rising interest rates and inflation.  A fed rate increase would trigger more capital outflows from emerging countries.  After 30 years, the bull market in bonds is over rates can’t go significantly lower.  The biggest losers this year have been emerging-market bonds in all asset classes.  These bonds have shown a negative return of 21.5%.  The local-currency of these markets posted a 25% decline in currencies against the dollar. Although the Fed rate hike would bring uncertainty for emerging markets bonds, it would encourage other countries to be more active on their monetary policies.  

     The likelihood of fed interest rate increase has brought volatility in the emerging market bond.  Emerging-market bonds declared their biggest one-day decline in about two years, since investors became concerned about the impact of increasing U.S. interest rates.  After a day of heavy and broad selling J.P. Morgan followed Emerging Markets Bond Index Plus (EMBI), which went down to about 2.27% (Leaviss, 2014).  That amount of decline had not been seen since June 2002 according to J.P. Morgan.  This shows the market is volatile and is evident by countries like Latin America who have been on a roller-coaster ride.  They are exposed to situations of monetary tightening, which could restrict the availability of funding for high-risk countries.  When the fed raises interest, the selloff in emerging-markets debt will be fierce.

   With a rate increase, China investors will sell their bonds to buy U.S. bonds, but they are expected to lower their interest rates to keep investors from leaving.  The fear is that a rise in U.S. rates could push capital out of the Chinese system, because investors would leave for higher returns through dollar deposits or yields.  However the People’s Bank of China believes they have adequate resources to counter the Fed’s rate increase, by lowering interest rates themselves.  Chinese companies have high levels of debt financed by dollar investors that would make it harder for them to repay loans and bond yields.  Since 1997 China took out short-range dollar loans to bankroll their operations while U.S. rates were small (Leaviss, 2014).  According to indicators about a fourth of Chinese commercial debt (bonds) is knotted to the greenback, but less that 10 percent of their profits are in USD.  The Fed is projected to raise U.S. rates in increments, which means China would see loss but could adapt to a gradual rate increase.

      The impact is being experienced now on Indian bonds with yields rising amidst fears of a sell-off due to the fed raising interest rates is pushing up market interest rates in India.  Indian sovereign bonds due in 2024 fell on worry of inflation and the federal interest increase. The return on the debt owed July 2024, which is the 10-year benchmark raised one basis point to close at 8.08 percent (Acharya, 2015).  It climbed to 8.12 percent, which was its peak level since Nov of 2014 before trimming some of its losses.  The Reserve Bank of India startled markets with unforeseen rate cuts, which should have prompted a rally in the bond market, but it didn’t ensue.  Investors looked for signals from the two-day Federal Reserve meeting in September (Acharya, 2015).  They looked for hints on the scheduling of an increase in U.S. interest rates, because rising rates will cause the exit of emerging-market bonds and investors would put their money in high-yielding dollar-backed assets (Das, 2015).  

     When the rate rises most likely the value of the dollar would rise, which means a significantly negative association in reference to the returns of bonds in the emerging markets.  Countries like Brazil and Mexico currency will be devalued and investors are expected to switch positions from Brazilian treasury bonds to U.S. bonds.  The bond switch will further impact the exchange rate and drive the Brazilian real lower against the dollar.  This year because of expectations of a fed rate increase the dollar has increased more than 14 percent against the real (Quinlan, 2014).  Investors smell panic and see stress, as the Fed has already started limiting credit by decreasing bond-buying enticement known as quantitative easing. Investors have come up with remedies for the Mexican economy; since it has already experience financial instability in the bond market when the Federal Reserve started limiting credit before raising interest rates.  

     Investors of emerging market bonds have come up with remedies to lesson the effects of future interest rate increases in emerging markets.  Some of the remedies are using floating-rate notes and shorter duration bonds of about five years to lessen the effects of a future rate hike.  In Mexico floating notes account for 83% of all liability sold in the local market this year (Roubini, 2015).  In the U.S. these same type bonds account for 18 percent of sales.  Mexico is the only key Latin American country that hasn’t increase interest rates in the preceding year.  Growing sales of floating-rate debt illustrates that Mexican businesses are content with their current monetary policy and perceive less inflation.   Their lack of preparedness will show when the fed raises the interest rate and there is a sell off.